If you’re thinking of buying a home in today’s market, you need to be prepared for the possibility of an appraisal gap.
So what is an appraisal gap?
An appraisal gap is when a home’s appraised value is lower than the purchase price the buyer has offered to pay. Appraisal gaps are becoming increasingly common in competitive markets like what buyers are facing today—and they can seriously complicate matters if you aren’t prepared.
“Today’s gaps are the result of market conditions,” explains Will Hedrick, the CEO of Speek Real Estate in Charlotte, NC. “Because buyers are faced with a low supply, the market has become very competitive, driving up prices.”
This can easily cause appraisal gaps to occur—sometimes wide ones amounting to tens of thousands of dollars.
Read on to learn what an appraisal gap is, how it could affect your transaction, and four ways to resolve this scenario.
What is an appraisal gap?
In real estate, an appraisal gap might occur when an appraiser estimates the value of the house to be lower than the offer price that has been agreed to by the homebuyer and seller. For example, if a buyer agrees to purchase a home for $400,000 but the property appraises for $375,000, there is a $25,000 appraisal gap that will need to be dealt with in the transaction.
This is a problem because lenders will typically cover a loan for only the appraised value of a home—so if that appraisal is lower than what the buyer has offered, the buyer is stuck covering the difference.
Lenders use a loan-to-value (LTV) ratio to determine how much money they can put out for a loan. This LTV ratio is a percentage of the home’s value. Most conventional lenders like banks prefer an LTV ratio of 80% (or lower), which means that buyers need to make a 20% down payment.
Yet when an appraisal comes in low, the total amount that lenders let buyers borrow changes.
Let’s say, for instance, that the buyer has agreed to pay the seller $400,000 for a house and is willing to make a 20% down payment amounting to $80,000. This leaves the lender with an LTV ratio of 80%. That’s all fine and good.
However, if the appraised value comes in lower, at $375,000, the bank will be willing to loan the buyer only 80% of that, or $300,000. Yet given the buyer has agreed to pay the seller $400,000, this would mean the buyer will need a total of $100,000 to cover the difference. In addition to the 80,000 down payment, the buyer will need to find an additional $20,000 to close the deal.
Best practices for handling an appraisal gap
As you can imagine, most buyers aren’t thrilled at the prospect of having to come up with thousands of extra dollars by the time they sit down at the settlement table. After all, not everyone has the cash on hand to cover a large unforeseen expense. Fortunately, we’ve collected some best practices to help you navigate an appraisal gap if one comes up in your transaction.
Include an appraisal gap clause in your offer
First, including an appraisal gap clause in your offer is a way to tackle this situation head-on. Using this clause, you can spell out for the seller what you are willing to do if an appraisal gap occurs. For example, you could agree to pay the full amount of the difference or to put a set amount of money toward the gap.
In short, including this clause in your offer can help you limit your exposure. Still, at the same time, since you’re willing to put extra money out for the home, it will also help give the seller a better sense of your motivation.
Request an appeal of the appraisal
When you request an appeal of an appraisal, you’re essentially asking for the appraisal to be redone by another neutral third party. The hope is that the new appraiser will think the property is worth more than the figure in the original appraisal. If so, you might be able to close the appraisal gap.
However, there is no guarantee that the new appraisal will be any different. If you decide to go this route, ask your real estate agent to provide comparables that support your proposed purchase price. That way, you’ll be able to provide evidence that supports your offer.
Renegotiate with the home seller
If there’s an appraisal contingency in your offer and your appraisal comes back low, you’ll have the option to renegotiate the purchase price with the seller. That said, again, there is no guarantee that the seller will be willing to accept a lower price. Especially in a competitive market, there is very little incentive for the seller to do so.
Walk away from the home
Last but not least, if you have an appraisal contingency, you are also within your rights to walk away from the home. While it might not be the ideal outcome, if you don’t have the cash to cover the appraisal gap and the seller is unwilling to budge on the price, it might be your only viable option.
For this and related articles, visit Realtor.com